What Constitutes an ‘F’ Reorganization?
An "F" reorganization is a tax-free business transaction in which a corporation transforms into another corporation without the complexities of other forms of reorganizations. According to the IRS: "In a reorganization under § 368(a)(1)(F), the following series of steps occur:Forms NF and C and a statement of identification are filed.June 17, 1999 Release, Cumulative Bulletin 1999-2, No. 11, pp. 7-10) The "F" reorganization occurs when a corporation pays its debt by transferring its property and discharges those debts with stock . It restructures its equity interest and, in turn, its debt for equity ratio. The reorganization improves the equity interest of shareholders and reduces the corporate debt. Some assets may or may not stay with the pre-failed corporation, or it may transfer all of its assets to the new corporation. The pre-failed corporation must retain at least one asset and its former name to receive tax benefits. In many cases, failing companies undergo an "F" reorganization to prevent bankruptcy.
Essential Legal Conditions for an ‘F’ Reorganization
Section 368 of the Internal Revenue Code defines the term, corporate reorganization, to include: a merger or consolidation (section 368(a)(1)(A)); the transfer by one corporation of all or part of its assets to another corporation in exchange for stock in such other corporation alone, followed by the distribution of the stock or securities in the transferee corporation by a transferor corporation, which is a party to the exchange (section 368(a)(1)(C)); a transfer of assets of a corporation to a controlled corporation in exchange for stock in such controlled corporation (section 368(a)(1)(D)); a transfer by a corporation of all or a portion of its assets to two or more corporations in pursuance of a plan of reorganization (section 368(a)(1)(E)); and a transfer, pursuant to the terms of a liquidation, by a corporation in exchange for the transferee’s voting stock in a controlled corporation in a transaction referred to as a recapitalization (section 368(a)(1)(G)). An "F" Reorganization encompasses a statutory merger or consolidation of one or more corporations into another, or a transfer of assets by one corporation controlled by another corporation in exchange for voting stock in such other corporation if the transfer or issuance of stock is carried out in such a way as to qualify for nonrecognition treatment under section 361. Accordingly, any corporate statutory merger or consolidation is an "F" Reorganization that is subject to the provisions set forth in section 368 (F). Transfers of stock can be made pursuant to a plan of reorganization or a transfer of statutory rights to which section 357 applies. Section 357 applies to any transfers to any corporation which control the property of any trade or business either directly or indirectly through an intervening subsidiary. The recognition of income for transfer of property in such cases is deferred to future income tax years.
Advantages of an ‘F’ Reorganization
The electing to undergo an "F" reorganization, rather than the default statutory merger, has numerous advantages that may make the "F" reorganization the preferred transaction. For example, the indefeasible advantages of reorganizations include: "F" reorganizations can be important tools to simplify operations, conserve resources, reshape corporations and even achieve lower tax rates. Companies that are considering business or corporate structure changes should carefully evaluate the benefits of choosing an "F" reorganization over a default statutory merger for the business’ corporate reorganization.
Common Use Cases of an ‘F’ Reorganization
There are a number of common situations in which a corporation may wish to consider an "F" reorganization. For example, in the context of a merger or acquisition, "F" reorganizations may be utilized to consolidate corporate structures to achieve operational efficiencies and cost savings. There are also times when an "F" reorganization may be appropriate in connection with inbound and outbound restructurings. Entities that hold passive assets and have little business operations may benefit from the tax savings and efficiencies of an "F" reorganization.
Another common scenario for an "F" reorganization is when the shareholders of a corporation seek to migrate the assets of that corporation to a parent corporation (to facilitate downstream mergers or filings of consolidated federal income tax returns), while maintaining the corporate existence of that subsidiary corporation (to facilitate later sales of that subsidiary corporation). In this scenario, an "F" reorganization may be accomplished through (1) a transfer of assets from one corporation to another in exchange for stock in the transferee corporation followed by (2) a liquidation of the transferor corporation. In such a case, the "F" reorganization provisions of the Internal Revenue Code may be applied in combination with the liquidation rules to achieve a restructuring of corporate ownership of a subsidiary without triggering the gain recognition and tax consequences that would otherwise arise from a sale of its stock or assets.
Pitfalls and Considerations
In addition to the structural rules, and the timing issues, there are a number of additional considerations associated with an F reorganization. Taxpayers may find that a foreign corporation will be subject to regulatory compliance obligations at federal, state, or local levels. For example, you may need to seek the approval of a regulatory agency in order to close the transaction. Alternatively, the transaction may trigger notification obligations. In particular, EPA, FCC, Federal Reserve, SEC, CFIUS (Committee on Foreign Investment in the U.S.), or various state level regulators may all have the potential to impact timeline or details of a transaction in a way that is not easily mitigated. Usual tax issues. Of course , the usual tax issues should also be considered. In particular, the IRS has some pre-filing requirements for F reorganizations, including a requirement to have an advisor opine on the entire transaction, not just the transaction from the viewpoint of a single entity. In addition, you should consider the treatment of the following gain and loss items: section 1248 amounts, foreign taxes paid or accrued, section 311(b) and 962 amounts, and foreign tax credit carryovers and carrybacks, if applicable, and whether it is possible to identify all payments that will be made in connection with the reorganization. Further, you should also consider whether any contracts to which you are a party will be impacted by the reorganization.
How to Effectuate an ‘F’ Reorganization
The first step a company must take if it wishes to transform into a holding company is to form a new holding company corporation that meets the statutory requirements. In order for the newly formed corporation to be a "subsidiary corporation" of the transferor corporation and to qualify as a subsection 368(a)(1)(F) transferor, it must assume the assets and liabilities of the transferor corporation. There is no requirement that the new holding company have business reasons for being formed. The only requirement is that the transferor corporation transfers its assets and liabilities solely in exchange for voting stock of the transferee corporation. The issuance of nonvoting stock will not result in a realization event for either corporation. However, it is important to note that if the transferee corporation has class(es) of nonvoting stock, it may result in a realization event for the transferor corporation. Thus, only voting stock should be issued for the transfer of assets and liabilities. A transferor corporation may receive voting stock with a value other than the value of the assets and liabilities transferred, but this will not affect the qualification of the transfer as a subsection 368(a)(1)(F) transfer.
The assets transferred to the transferee corporation must consist of all or substantially all (determined based on an amount realized by the transferor) of the transferor corporation’s assets, and the transfer may be accomplished in one or more transactions. This does not apply if properties of the transferor corporation are distributed to shareholders for other stock in the transferee holding corporation. Unlike section 368(a)(1)(B) exchanges, an "F" reorganization does not require that each shareholder of the transferor corporation transfer property solely for voting stock in the transferee corporation. Instead, if the transferor corporation distributes property, other than voting stock, to its shareholders for transferee corporate voting stock, the transfer will still qualify as a subsection 368(a)(1)(F) transfer to the extent that the transferor submits proof that the transfer of property has been adequately accounted for in exchange for voting stock. In the event that a shareholder receives property other than transferee corporate voting stock in the exchange, it will be included in gross income as a dividend to the extent of the transferor corporation’s earnings and profits. Any distribution exceeding the shareholder’s basis in the transferor corporation’s stock will be treated as a return of capital to the extent of the shareholder’s adjusted basis in the stock, and the amount in excess of such adjusted basis will be treated as gain from sales or exchanges.
If the transferor corporation has reported its income on a cash or accrual basis, it will be required to sign an election statement to adjust its taxable year(s). The transferor corporation elects to close its books as of the end of its latest taxable year. If the transferor corporation has a fiscal year end of June 30 or earlier, the transferee may designate a portion of its initial annual accounting period that will own the same year end as the transferor corporation to eliminate an interim stub period.
Potential Use Cases and Examples
To better illustrate the practical application of the requirements for an "F" reorganization, consider the following real-world examples of some companies that have successfully implemented "F" reorganizations:
In 1996, Pepsi-Cola Atlantic Corporation ("PCAC") a division of PepsiCo, Inc. pursued an "F" reorganization to accommodate a contraction in its market share in the bottled soft drink industry. PCAC’s "F" reorganization was recognized because it satisfied the requirements of both I.R.C. § 368(a)(1)(F) and the "substantially identical stock" test.
A number of pre-transaction steps were taken with respect to the reorganizations. First, PCAC formed a new, wholly-owned subsidiary called PBCC in order to receive contributions of stock in the parent company’s subsidiaries along with the assumption of related indebtedness. PBCC was then merged with two existing PCAC subsidiaries in a tax-free reorganization under I.R.C. § 368(a)(1)(F) with the surviving entity being the newly formed PBCC. The surviving corporation then transferred the stock received in the contribution of such stock and dividends into two new, wholly-owned subsidiaries. The new holding company was then liquidated, the assets of the liquidating entity were transferred to the parent corporation, and the transaction was completed while avoiding the recognition of any tax consequences.
In the real estate industry, the development of a successful "F" reorganization can be seen in the case of Grossmont Center Associates , Ltd. ("Grossmont"). In 1999, the owners of Grossmont, a limited partnership, completed a Sale/Lease Back Reorganization under I.R.C. § 368(a)(1)(F), and thus avoided the tax consequences which would have been incurred had the sale involve the individual partners. The structure of this transaction involved the successive transfer through an "F" reorganization of a series of entities, first from the original owner to two trusts, then to a limited liability company, and to a newly created qualified captive insurance company. In the Grossmont capitalization structure, all outstanding interests in the limited partnership were exchanged for transferee stock, with the exception of the preferred partnership interest held by an individual who was also a general partner. The individual was retained as a general partner of the new entity and received rights to receive annual guaranteed payments, which were co-mingled with the dividends paid on the preferred stock. The company completed the transaction to obtain additional financing available only to a corporation and not the partnership, what had originally been viewed as an asset sale allowing partners to be taxed at capital gain rates and take certain deductions. It is worth noting that several of the individual partners complained to the IRS regarding this structure and were provided assurances that it did not satisfy the "substantially identical stock" test. Nonetheless, no adverse ruling or letter was ever issued to the partnership.